(Script) BUS-91- Target Costing.docx

**BUS-091 MANAGERIAL ACCOUNTING** **Module 4** **Target Costing** **(Script)** In this video, we\'re going to discuss target costing. target costing is a pricing strategy, and an alternative to cost plus pricing. if you\'re not familiar, the way cost plus pricing works is you say, it costs us \$...

**BUS-091 MANAGERIAL ACCOUNTING** **Module 4** **Target Costing** **(Script)** In this video, we\'re going to discuss target costing. target costing is a pricing strategy, and an alternative to cost plus pricing. if you\'re not familiar, the way cost plus pricing works is you say, it costs us \$40 to make this product, and we mark up all our products by 25%. So we\'re going to sell this product for \$50. Every time we sell a product, we will make a \$10 profit per unit. The way target costing works is you set the price first and determine the maximum allowable costs to make that product. then you design the product in such a way that you are not going to exceed the maximum allowable costs. This is related to the concept of value engineering. From designing the product you make sure we are not going to exceed the target cost. For example, let\'s say the expected selling price of our product is \$60 a unit. And our target profit is we want a target profit of \$50. on every unit that we sell, then our target cost would be 45 a unit. In other words, we are going to design this product in such a way that it does not cost more than \$45 a unit to make. If it goes more than \$45, we are not going to achieve our target profit. We have failed. Okay. So we set the price first and then we say, okay, what\'s our target profit that we want that tells us our target cost. And we need to Get either at \$45 or below 45 in order for this to be a success So cost plus pricing, the idea is that we\'re going to say, let\'s build the product first. And then once we built the product and seen what it costs, then we\'ll figure out the price based on the cost. We\'ll just take the cost and mark it up. But with target costing. You say, look the price is just fixed. The price is whatever it is. In this case, we said \$60, but whatever the price is, we fixed it. And we say, okay, now we\'re going to build the product so that the cost is low enough to achieve the profit that we want to achieve, which in this example was \$15. So, you know, right up front what the price is going to be, and you\'re trying to meet this target cost. when you\'re designing the product, you are trying to avoid overengineering. that means Building in features that the customer isn\'t necessarily going to value and want to pay extra for. target costing is very different than cost plus pricing. You\'re trying to make sure that no matter what happens, you come in below that maximum allowable cost. let\'s do an example. Let\'s say your company is going to introduce a new product. an ultralight hiking backpack. And you\'re going to compete with the CDT pack that is made by the company ULA. Okay, so ULA is a real company and they make the CDT pack and they sell it for, as of the time of this video, \$145 to buy one of these CDT packs. That\'s a picture right there. So your firm, let\'s just say that they want to compete on price. So they\'re not going to have any better features or anything than this, than the CDT pack. They just want to have a similar pack that is cheaper. So they say, okay, let\'s say your marketing team. You talk to the marketing team and you say, okay, what should be the price? And they said, look at a price point of \$140. That\'s where we feel comfortable. We\'re going to undercut. So the CDT is one \$45. We\'re going to go with one \$40. That\'s just what\'s going to happen. And we think we\'re going to sell 5, 000 of these backpacks. So you say, okay, what is our target profit? We can think about that. Well, if we\'re, let\'s just say that there\'s going to take an investment of \$300, 000 to launch this new product line, you could think of that as working capital tied up, however you want to think about it. And let\'s say the required rate of return is 20 percent for our company, I\'m just saying that, that, that\'s a, that\'s what your company has decided that it wants 20 percent return on any projects. So basically you\'d say 20 percent times \$300, 000. They\'re wanting to make. \$60, 000 profit. the maximum allowable cost, the target cost in this situation is going to be \$640, 000. If you divide that by 5, 000 packs, which is what we said they think they\'re going to sell, it\'d be \$120 a pack. Let me go through each step and walk you through this so you completely understand First, we said, What do we think we\'re going to do in sales based on the price? Remember, we set the price first. We\'re not going to build the product figure out how much it costs and then later go and set the price. in this case, we say, it was 140. That\'s going to be our price per unit, 5, 000 packs. So that\'s going to be \$700, 000 in terms of revenue this is our sales here, \$700, 000. Now the desired profit, I already told you, so \$300, 000 of capital at 20 percent rate of return. our company is saying, if we do this, we want to have a profit of at least \$60, 000. So if we\'re going to do \$700, 000 in sales and we want to have at least 60, 000 profit, that means the target costs, the maximum allowable costs. is \$640, 000. So that\'s where I get this number up here.\$ 640, 000, just our sales minus the profit. That\'s going to back out what the cost can be. If the cost is more than \$640, 000, then it has failed. We are not going to achieve Our desired level of profit. Okay, so let\'s say the cost comes in at \$690, 000 or something like that. We\'re not going to achieve a \$60, 000 profit. It\'s not going to happen. So here\'s another way of thinking about it instead of just thinking \$640, 000. If we divide that, so we\'d said we\'re going to sell 5, 000 packs. Okay, so if you divide the \$640, 000 total cost by 5, 000, you get the target cost on a per unit basis, which is \$128, We are saying, look, we\'re going to sell this pack for \$140 a unit. That\'s the price. So we need to design this backpack. In such a way that it does not cost more than \$128 per backpack to make in order to achieve our desired level of profit.